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Continued from page 2

If instead, Marcellus and Mia sell the stock in December 2012, the $30,000 gain will be taxed at only the 15% long-term capital gains rate. Because the wash sale rules don't apply to capital gains, Marcellus and Mia can purchase the same stock immediately after the sale.

Take a hard look at tax-exempt bonds. Assuming the Bush tax cuts expire at year-end, wealthy taxpayers will pay tax on interest income at a maximum rate of 39.6% plus the 3.8% Medicare tax in 2013 and beyond. Net investment income, however, does not include tax-exempt income. As a result, if you reside in the highest tax bracket, a 3% tax-exempt bond will now earn you the equivalent after-tax return of a 5.3% taxable bond (3%/(1-.434)).

Meet the material participation test for your S corporation or partnership. In general, when a taxpayer is merely a passive investor in an S corporation or partnership, any loss allocated to the taxpayer cannot be used to offset non-passive income from other sources. As a result, taxpayers who are allocated losses from a flow-through entity will typically prefer that their involvement in the activity be considered non-passive, so they can offset the losses against other taxable income without limitation. In 2013, however, taxpayers with income from an S corporation or partnershipwill also have a vested interest in avoiding a passive classification, because as mentioned in the introduction, the 3.8% Medicare tax will apply to income earned from a passive activity, but not from a non-passive activity.

In simple terms, your interest in an S corporation or partnership is passive unless you meet one of seven "material participation" tests found in the Section 469 regulations:

1. You participate in the activity for more than 500 hours during the year,

2. Your participation in the activity constitutes substantially all of the participation by all individuals (including nonowners) in the activity for the year,

3. Your participation is more than 100 hours during the year, and no other individual (including nonowners) participates more hours than the taxpayer,

4. The activity is a significant participation activity in which you participate for more than 100 hours during the year and your annual participation in all significant participation activities is more than 500 hours. [A significant participation activity is generally a trade or business activity (other than a rental activity) that you participate in for more than 100 hours during the year but do not materially participate in (under any of the material participation tests other than this test),]

5. You materially participated in the activity for any five tax years (whether or not consecutive) during the 10 immediately preceding tax years,

6. For a personal service activity, you materially participated for any three tax years (whether or not consecutive) preceding the current tax year, or

7. A generic facts and circumstances test.

In 2013, pumping a few extra hours into your S corporation or partnership activity could be the difference between saving or shelling out an extra 3.8% in tax on the resulting income.

Example: Danny Noonan, a single taxpayer, is employed full-time as caddy at a prestigious country club, where he draws a $200,000 annual salary. On the side, Danny also owns 50% of an S corporation that serves burritos outside of a local bar from 2-4 AM every Saturday night. The stand is quite profitable, generating $50,000 of flow-through income to Danny every year. During 2012, Danny put in 90 hours building and serving burritos. The other 50% shareholder, Tony, contributed only 70 hours. The S corporation has no other employees.

Assume Danny did not materially participate in the S corporation under any of the regulatory tests during 2012. In 2013, there is tremendous motivation for Danny to work an extra 10 hours at the burrito stand. Doing so would allow Danny to satisfy material participation test #3 because he would have 1) worked 100 hours, and 2) worked more hours than anyone else in the burrito stand activity.

By meeting the material participation test, Danny would remove the $50,000 of income allocated to him from the S corporation from the definition of net investment income, as the activity is no longer passive under the meaning of Section 469. As a result, Danny saves $1,900 in additional Medicare tax.

There are additional complexities when the activity is conducted through a limited partnership or LLC. Under Section 469(h)(2), an interest in a limited partnership as a limited partner is generally treated as a passive activity, regardless of the partner's level of participation.

Until recently, this rule had been unilaterally been applied to members in an LLC, but in two recent court cases -- Garnett v. Commissioner, 132 T.C. 639(2009) and Thompson v. Commissioner, 87 Fed Cl 728(2009) -- the Tax Court and Federal Court of Claims, respectively, ruled that interests in an LLC were not automatically treated as passive. Rather, if state law grants the LLC member the right to participate in management, the courts concluded that the LLC more closely resembles a general partnership, and the members are permitted to look to the seven regulatory tests in order to establish material participation.

Thus, courtesy of Garnett and Thompson, an LLC member who materially participates in the partnership will not be treated as a passive investor, and as a result, will avoid the 3.8% Medicare tax on the resulting flow-through income.

Be advised, however, that if you materially participate in an LLC, it will likely sentence you to reporting any income as subject to self-employment tax. So in effect, you may be trading an additional 3.8% tax on a small portion of income for a 15.3% tax on a lot of income.

Example: Dignan, a single taxpayer, owns an interest in a LLC that conducts an active trade or business. Each year, Dignan is allocated $300,000 of income from the LLC, comprising all of his income. During 2012, Dignan worked 495 hours for the activity and did not meet any of the other material participation tests.